Collateral Eligibility

Collateral eligibility is the body of rules that decides whether a given asset can be used to secure an obligation. Every collateralised relationship, whether a derivative contract, a repo, a securities loan, a cleared position or central bank credit, depends on a definition of what the collateral taker is prepared to accept. Assets that meet the definition are eligible collateral; those that do not cannot be delivered, however valuable they may be.

Eligibility is distinct from valuation. The first asks whether an asset may be used at all; the second, covered under collateral valuation, asks how much credit it earns once accepted. The two are set together, usually in a schedule that lists each permitted asset class with its collateral haircut. Who sets the rules varies: the two parties in a bilateral agreement, a clearing house for its members, a central bank for its counterparties, and regulators for certain purposes.

A collateral taker wants assets it can sell quickly, at a predictable price, if the provider defaults. The criteria reflect that aim:

• Asset type. Cash in major currencies and government bonds are almost always accepted. Corporate bonds, covered bonds, equities in main indices, securitisations and gold may be accepted on stricter terms.
• Credit quality. Issuers or issues must meet a minimum credit rating or internal assessment.
• Liquidity. Securities must trade in deep markets, often tested by issue size or index membership.
• Currency and jurisdiction. Limits may apply to the currency of denomination and the country of the issuer or of the depository where the asset is held.
• Maturity. Very long-dated bonds may be excluded or carry larger haircuts.
• Independence from the provider. Securities issued by the collateral provider or its affiliates are excluded, because their value would fall just when it is needed. This is known as wrong-way risk.
• Concentration. A collateral concentration limit caps the share of a pool that may consist of one issuer, sector or asset class.
• Legal and operational certainty. The taker must be able to obtain an enforceable interest in the asset and settle it through its custodian or depository.

In a bilateral collateral agreement, eligibility is negotiated. The credit support annex (CSA) to a derivatives master agreement contains a table of eligible assets and their valuation percentages. A wide schedule gives the provider flexibility to deliver whatever is cheapest for it, but it makes the collateral harder for the receiver to value and reuse. Many dealers have moved towards narrow schedules, sometimes cash in a single currency, to simplify pricing.

Repo and securities lending work in a similar way. In a general collateral repo, the lender of cash accepts any security from an agreed basket. Where the parties use tri-party collateral management, they define eligibility schedules with the agent, which then selects assets from the provider's account that satisfy them and substitutes automatically as holdings change.

For derivatives that are not centrally cleared, margin regulations based on the international framework limit collateral to defined classes, including cash, high-quality government and corporate bonds, covered bonds, equities in major indices and gold, and they require haircuts and attention to concentration and wrong-way risk. A central counterparty (CCP) publishes its own list, generally restricted to cash and highly liquid securities, since it must be able to liquidate a defaulting member's collateral within days.

Central banks define eligibility for their lending operations. The Eurosystem, for example, maintains a single framework covering marketable assets and certain non-marketable assets such as credit claims, with credit quality thresholds and haircut categories, applied by the European Central Bank (ECB) and national central banks.

Bank liquidity regulation uses a parallel concept. The liquidity coverage ratio (LCR) counts only high-quality liquid assets, defined by criteria much like those above. Assets that qualify under several regimes at once are especially valuable.

Eligibility rules must be translated into data that systems can apply. Each schedule is encoded as a set of tests against attributes of a security, such as issuer type, rating, currency and maturity, and each position is checked before it is delivered. Errors lead to rejected deliveries and failed margin calls. Because ratings, index membership and outstanding amounts change, a security that was eligible yesterday may not be today, and it must then be replaced through collateral substitution.

Eligibility also shapes the economics. A firm will generally deliver the least valuable asset that a counterparty will accept, and the scope for doing so is the starting point for collateral optimisation.

Efforts continue to widen the usable pool safely. Tokenised forms of existing assets are being tested as a way of moving collateral faster and outside normal settlement hours; see tokenised collateral. Regulators weigh such proposals against the central requirement that collateral must hold its value and remain saleable in exactly the conditions under which it is likely to be called upon. Day-to-day application of the rules is part of collateral management.